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The marginal productively theory is an attempt to explain the determination of the rewards of various factors of production in a competitive market. The marginal productivity theory of resource demand was the work of many writers, it was widely discussed by many economists like J.B. Clark, Walras, Barone, Ricardo, Marshall. It was improved, amended and modified later on. The final version of the theory of marginal productivity as stated by neo-classical economists is given below.

Definition and Meaning:

By marginal productively theory of a factor is meant the value of the marginal physical product of the factor. It is worked out by multiplying the price of the output per unit by units of output.

Formula:

VMP = MP x P

Value of Marginal Product (VMP) = Marginal Physical Product x Price

The marginal productivity theory contends that in a competitive market, the price or reward of each factor of production tends to be equal to its marginal productivity.

Explanation with Example:

The demand for various factors of production are a derived demand. The resources do not usually directly satisfy consumer wants. They are demanded because these help in producing goods and services. An entrepreneur while hiring a factor of production calculates the contribution which it makes to total production and the amount which has to be paid to it in a competitive market. An individual firm cannot influence the price of the factor of production. It has to take the ruling price in the market as given. The firm can employ as many number of factors units as it wishes at the ruling price of the factor.

It has been observed that as a firm hires increasing amounts of a variable factor to a combination of fixed amounts of other factors, the marginal productivity increases up to a certain stage of production and then it begins to decline. The buyers of a factor of production while deciding whether one more unit of factor should be employed or not, compares the net addition which it makes to total revenue and the cost which has to be incurred on engaging it. If the marginal revenue product of a factor is greater than its marginal cost, the entrepreneur will employ that unit because it earns more than what he has to spend on employing the additional unit.

As he employs more and more units of factor of production, the marginal revenue productivity increases up to a certain limit and then it begins to decrease. On the other hand, marginal cost decreases as production is expanded. After a certain point, when business becomes difficult to manage, marginal cost begins to increase. When both marginal revenue productivity of a factor and its marginal cost are equal, (MRP = MC) the entrepreneur stops giving further employment to a factor of production.

The last variable unit which an employer just thinks it worthwhile employing is called the marginal unit and the addition made to the total production by the employment of the marginal unit is called marginal productivity or marginal revenue productivity. The entrepreneur will pay the remuneration to each factor of production according to its marginal revenue productivity.

Schedule:

The marginal productivity theory is explained with the help of a schedule (table):

Demand for a Factory or Resource (Daily):

Rule for Employing a Factor of Production:

An entrepreneur is to maximize its profits. While hiring any resource, he compares the marginal revenue product of a factor with the additional cost he has to pay. So long as the marginal revenue product is greater than the marginal cost of the factor, he will continue hiring it. When the MRP of the factor is equal to its MC, he will stop engaging more labor. The firm at this point will be in equilibrium and maximizing profit.

In the table above, the entrepreneur adds more to its total revenue than to total cost up to the fifth unit. When he hires the sixth labor, the MRP = MC. The firm here is in equilibrium and maximizing profits, In case, the 7th worker is hired, the MRP is then < MC. The firm suffers loss and is not reaping the optimum profit.

Least Cost Combination of Resources:

There are a number of resources which are required for the production of a commodity. The entrepreneur can maximize his profit only if the least cost combination can be arrived at by equalizing the ratios between the marginal products and the prices of the different factors of production. If the ratios differ, then it is in the interest of the employer to make necessary adjustment by employing more of one factor and less of other till be ratio between the marginal productivity and price of each factor becomes equal. The least cost combination will be achieved, when:

In the long run, under conditions of perfect competition, the price of each factor of production is already determined in the market. An individual entrepreneur cannot affect the market price of various factors of production by his own individual action as his demand for a factor or factors forms only a small part of the total demand. He is a price taker. So, what he does is that he goes on employing each factor of production up to a point which makes marginal revenue productivity of the factor equals to its price.

Diagram:

In the figure 18.1, the supply of labor is perfectly elastic. The wage (W) is equal to average wage (AW) and marginal wage, (MW) = W = AW = MW.

At point E, the MRP of labor is equal to marginal wage (MW). The producer is in equilibrium at point E. He will employ ON units of labor because when ON units of labor are employed, the marginal revenue productivity of labor MRPL = Wage. To the left of E the MRP of labor is higher than wage (MRP > W), the producer will increase the units of labor. To the right of the MRPL < wage, so the firm will curtail the units of labor. It is only at point E, the firm is in equilibrium where MRPL = Wage.

Assumptions:

The theory of marginal productivity is based on the following assumptions:

(i) Factor identical: It assumes that all the units of a factor are exactly alike and so can be substituted to any extent.

(ii) Factors can be substituted: It is assumed that the various factors of production, which help in the production of particular commodity can also be substituted for one another. We can use more of labor or less of land or more of labor and less of capital.

(iii) Perfect mobility of factors: It is assumed that the various factors of production can be moved from one use to another.

(iv) Application of law of diminishing return: The theory rests on the assumption that the law of diminishing returns applies also to the organization of a business.

(v) Perfect competition: It is based on the assumption that the reward of each factor of production is determined under conditions of perfect competition and full employment.

Criticism:

The marginal productivity theory has been subjected to scathing criticism on the following grounds.

(i) Theory based on unrealistic assumptions: The theory is based on a very wrong assumption, that all the units of a factor of production are homogeneous. The fact is that neither all land, nor all labor, nor all capital, nor all organizations are alike. We know it very well that labor varies in efficiency; capital in form, land in fertility and entrepreneur in ability.

(ii) Factors are not perfect substitutes: It is also wrong to assume that the factors of production are close substitutes for one another. Labor is not a perfect substitute for capital, and vice versa. So is also the case with land in relation to other factors of production.

(iii) Law of proportionate return: The theory rests on a very wrong assumption that the law of diminishing returns applies to a business. Is this not a fact that when there is proportionate increase in the factors of production, the law of diminishing return is held in abeyance in all businesses.

(iv) Wage cuts does not determine demand: According to this theory, if employment is to be increased, the wages should be lowered. J.M. Keynes vehemently disagrees with this view and says that this may be true in case of an individual firm or industry but it is wrong when it is applied to aggregate or effective demand.

(v) Difficulty In the measurement of MP: The other criticism levied on the marginal productivity theory by Taussig and Davenport are that production is the outcome of joint efforts of different factors and so it is not possible to separate the contribution of each factor individually.

(vi) Effect of withdrawal of a factor: Hobson criticizes this theory on the ground that if a factor of production which works in co-operation with other factors is withdrawn, it will disorganize the whole business and it may result in the decrease of production which may be greater than the addition made by the factor withdrawn.

(vii) Factor units cannot be raised: Another criticism levied by Hobson on the marginal productivity theory is that there are many cases in which the variations in the use of factors is not possible. The proportion in which factors of production are to be employed is already determined by the technical conditions prevailing in a business. For instance, there are many machines for the working of which only one labor is required. If we engages two labors, it will not be of much use. A variation in proportions in such cases are not possible, therefore, the marginal productivity of such a factor cannot be ascertained.

(viii) One sided: The marginal productivity theory is also criticized on the ground that it assumes the supply of a factor or factors as fixed while in reality the remuneration paid to a factor does influence its supply. As the theory approaches the problem only from the side of demand and neglects the effect of supply, therefore, it cannot be accepted as true.

(ix) Static theory: Marginal productivity theory neglects the problem of technical change altogether. It is therefore, static theory.

Conclusion:

From all that we have said above, it can be concluded that the theory of marginal productivity is true only under the assumption of perfect competition and state of full employment. Fraser has commented on the theory of distribution as such:

“No economist would claim that theory is as yet complete, even as a purely academic structure of framework. It has the defects of its quantities being simple and self-consistent; it is abstract and impersonal it is quantity of sins both of omission and commission; its postulates are unduly rigid and narrow”.

In the words of Samuelson:

Marginal productivity theory is not a theory that at explains wages, rent or interest; on the contrary, it simply explains how factors of production are hired by the firms, once their prices are known”.